Capital Ideas: The Improbable Origins of Modern Wall St… (2024)

Your investment manager or stock broker probably believes he can beat the market-- ie: do a better job investing your money than simply putting your money in an index fund. And he is wrong. Anyone who says "I can beat the market" is a liar. "Buy and hold" is a better strategy for the investor than actively trading. As Nobel laureate Eugene Fama recently pointed out (again) using data from 1984-2006:

Even before expenses, the overall portfolio of active mutual funds shows no evidence that active managers can enhance returns. After costs, fund investors in aggregate simply lose the fees and expenses imposed on them.

As more players enter the capital markets, the markets become more strongly efficient. This is why I have a problem teaching finance-- I see too many students graduate who think they are somehow smarter than the market. Granted, one aspect of Efficient Markets Hypothesis may not hold to be true -- the underlying price may not always be right (and see my review of Taleb's Fooled by Randomness or Mandelbrot's The (Mis)Behavior of Markets) and risk may be grossly misassessed due to false assumptions of normality.
But people who are able to see mispriced assets or missassessed risk either don't exist or are too far and between. Bill Miller became a legend for managing a fund that beat the S&P 500 for 15 consecutive years (the only one to do so). Now his fund is the worst performing of its class and he's lost tens of billions of dollars.
This is also why I don't want to be an investment manager or try to sell someone the idea that I could pick the best mutual funds for them, because the data say that active management is ludicrous. All I could do is match their risk tolerance to the stated risk of the fund, like selling them the color car they want to drive.

Capital Ideas: The Improbable Origins of Modern Wall Street by Peter L. Bernstein is a classic history of modern finance. How academic economists and mathematicians revolutionized finance, and how the investment services industry fiercely resists their ideas. From determining the fair price of an option to designing the optimally diversified portfolio, Bernstein tells the story of how it all took place from Bachelier to Rubinstein.

Last summer, I read Bernstein's Against the Gods (my review here), which told the history of risk and is a good prelude to this book. What Taleb and Mandelbrot argue is that the tools used in Bernstein's book are folly for risk management because of the models' underlying assumptions--the world is not normally distributed. 1987 is an "aberration" Bernstein glosses over, and 2008 made Taleb and Mandelbrot rock stars (Taleb calls for every Nobel economics winner in Capital Ideas to be stripped of their awards).

As far as comprehensive history, this book is tough to beat. It has been required for our Jan term class for the last several years, which is why I needed to read it (although I'm not requiring it). After the dot-com crash of the 1990s, Bernstein wrote a sequel "defense" of his "heroes" which I would like to read.

4 stars out of 5.

The ideas in Capital Ideas have been covered elsewhere, but probably never as well. Peter Bernstein looked into every old academic journal and interviewed every old economist to help him understand how new ideas about efficient markets and financial engineering penetrated Wall Street and reshaped American finance. It’s a great story of abstract economic speculation having a profound effect on real lives and real money. Bernstein himself is in a perfect position to explain these conjoined developments, since he worked as an academic economist and also ran a brokerage shop on Wall Street for decades.

While early Wall Street Journal editors Charles Dow and William Peter Hamilton argued that smart forecasters could predict changing tides in the market (the “Dow Theory”), a tubercular man named Alfred Cowles who invested his family’s Chicago Tribune money decided to find out if they were right. After the 1929 Crash proved most of them wrong (Hamilton predicted it, but he had also predicted a crash in 1927, and two in 1928), Cowles founded the Cowles Commission for Research in Economics. With the help of Irving Fisher of Yale, he also founded the Econmetrica journal and discovered that most stock-pickers lost relative to the market. When Henry Markowitz worked with the Cowles Commission as a graduate student (of Jacob Marshak) at the University of Chicago in the 1940s, he used this data and research to formulate his theory of Portfolio Selection, which argued that there was an inevitable, and constant, tradeoff between risk and reward, and that risk was actually just a measure of the variance in one stock portfolio and the rest of the market. When the Cowles Commission moved to Yale in 1956, its new director James Tobin used Markowtiz’s insights to show there was in fact one perfect portfolio for all individuals, and that all variations in risk should be managed by the amount held of a “riskless asset,” namely cash. Later, William Sharpe, working with Markowitz while the later was at RAND near UCLA, developed the idea of a single “index” by which all stock returns could be measured, which also helped simplify computer calculations about successful stock picks.

Other research influenced the budding new theories. In 1934 Holbrook Working showed that wheat prices followed a “random walk,” and couldn’t be predicted from former price changes. He showed random number charts to commodities traders and proved they could not differentiate them from actual market price changes. Later, at Carnegie Tech, the old hyperkinetic Keynesian Franco Modigliani and the Boston-born Merton Miller, argued that stock values were entirely independent of the way a company was financed, and that the best way to evaluate a company's investments was to see its effect on stocks.

These ideas all cumulated in the Capital Asset Pricing Model (CAP-M), created independently by William Sharpe, Jack Treynor, and John Lintner around 1963, and the Black-Scholes Options pricing model of 1972. These revolutionized the way stock brokers traded through showing that the overall risk in the stock market was the crucial variable to know and that variance of that risk for stocks and options was the crucial determinant of value.

Bernstein shows how these ideas gradually penetrated markets. They led directly to Wells Fargo’s first “index fund,” the Stagecoach Fund, and then to portfolio insurance for stocks in the 1980s. Bernstein points out the growth of the computer was essential in this change, since it allowed traders to use the complicated math models of the economists on the trading spot. On the whole, despite wallowing in too many obscure characters, this is another great book showing how great ideas really matter.

The book ( along with the sequel Capital Ideas Evolving ) gives a very thoughtful and interesting account of various quantitative (often Nobel prize winning) theories and their role in shaping modern wall street. The author has interviewed virtually every Nobel prize winner in financial economics and share unique insights on their theories and their applications in the model world. On the theoretical side it touches on diversification, efficient markets, CAPM, portfolio constructions, derivatives & Black-Scholes. On the practical side (more in the sequel Capital Ideas evolving) it gives several insights into active v/s passive investments ( and how theories CAPM played a part ), index funds, portable alpha, alpha-beta separation, and finally ends with the Black-Litterman model. The author has interviewed (again in the sequel) practitioners at Barclays, Yale Endowment Funds, Barra Inc, Goldman Sachs Asset Management giving novel insights on the central role that theoretical ideas play in managing billions of dollars in their funds.

The second best book ever written on finance. A brilliant exposition of fundamental academic theories that made successful investment products. But that's not the best part of this book. The book brings out the underdogs of finance - the academics who made investing in stocks safer, sounder and cooler. It lucidly explains - even inspires - why stock markets are not the casinos they're made out to be. It explains simply, sometimes with humor, why stock markets are a great invention in economic history, as they make risk taking possible. Every society needs to support institutions that make riskier decisions possible. Societies don't progress, living standards don't improve unless inventors risk being wrong. Stock markets make these beautiful dynamics possible. Bringing this out beautifully, without compromising on accuracy, is the best contribution of this absolutely amazing book.

Book two of the three part Capital Ideas series is focused on the pioneers of modern day finance as opposed to Book One, which focuses on the broad history of risk & finance.

We are introduced to the core concepts of modern finance & their creators - efficient markets, portfolio diversification and derivatives/options pricing. This is more of a biographical and historical story of the ideas & their creators, with less focus on the actual math underpinning the theories (thankfully). A must read for anyone who is interested in markets & finance - these ideas are taught to all finance undergrads, but the context Bernstein brings rounds out the education.

A 4 for those interested in finance, a 2.5/3 for the general reader. This book is more finance & market focused than the first, and is thus less accessible.

Didn't get too many entirely new ideas from this one, but Capital Ideas truly satisfies my fantasies for a good, fun book - colourful legends of (academic) finance in a story format, interacting with each other and pushing along the narrative that would soon dominate the halls of business schools (and make the lives of economics students hell in the process. To this day - f*ck you, Arrow and Debreu. And your Arrow-Debreu securities, whatever tf that is.)

Bernstein also seemed to lose steam slightly by the latter quarter of the book. He goes into a forage into a couple minor characters that 'took gown to town'. Didn't feel like it was a natural or satisfying extension of the development of financial theory. Those firms don't exist anymore other than BARRA. Hell, a short chapter about Vanguard or DFA might be more interesting.

Also feel like Bernstein's exposition might benefit from considering all sides of the argument. For what it is, his case is so biased to the viewpoints of the academics, although I fully appreciate that he was proselytized by the academic gospel, from his roots as an investment counsellor himself, which shows that he's a pretty open-minded and undogmatic fellow despite what his books may paint. A deeper dive into the arguments of the value bros and active managers like Klarman or Buffett, who hate academic theories like EMH and MPT with a passion, would serve for a more well-balanced study. That fight still remains unresolved, but by looking between the lines, I realize both camps are saying the same thing anyway, and they themselves seem to not even realize it.

This book depicts the tales of the proponents of the Efficient Market Hypothesis, including the following:
Fisher Black, Eugene Fama, William Fouse, Hyne Leland, Harry Markowitz, John McQuown, Robert C. Merton, Merton Miller, Franco Modigliani, Barr Rosenberg, Mark Rubinstein, Paul Samuelson, Myron Scholes, William Sharpe, James Tobin, Jack Treynor, and James Vertin. It discusses the origins of the dividend discount model, CAPM, the Black-Scholes option pricing model, and other models.
The book displays the weaknesses and strengths of the EMH, but urges you to follow the ways of the theorists, to help make the market more efficient, and thus help make the world a better place.
It is obviously a few years old, and thus doesn’t really grasp the idea that EMH may never work, because unlike the laws of physics and math, the laws of economics/finance are based on the will of humans, who are fallible. In other words, they aren’t laws, more like guidelines, that can be followed, or ignored.

It was an interesting read, but somewhat dry. I can’t recommend this for anyone but those interested in the history of finance, and EMH. Any others will likely get bored...

The late Peter L. Bernstein's Against the Gods is the quintessential book on the phenomenon of risk. After several re-readings over the years it still stands up. That epic book prompted me to delve in another Bernstein opus, Capital Ideas. While this study of seminal ideas that shaped Wall Street has its merits, it is less likely to be re-read and referenced. Bernstein profiles the theorists who came up with models, hypotheses and instruments like CAPM, the efficient market hypothesis, the random walk and portfolio insurance. The book has a biographical bent, focusing on the nuances, habits and oddities of philosophical titans like Harry Markowitzh, Myron Scholes, Paul Samuelson and Fisher Black. Sadly, instead of an illuminating provocative insight into the forces driving modern business (which you are likely to get from Against the Gods), I received a rather cursory, superficial history lesson that has become fairly outdated and irrelevant. Still, Bernstein has a flair for spinning stories and thankfully does not immerse himself in complex algorithms and hieroglyphics.

A good -- if ideologically uncritical -- history of the theories and theoreticians of modern finance, including the influence of the Chicago school. This is a book written by someone who believes(d?) in the system, so one shouldn't expect questions of human impact or ideology. It's all about the numbers. But if you ever wanted to understand the previous century on Wall Street (up to the early 90s) from that perspective, this isn't a bad place to start. I'm curious how the current economic situation would be described/perceived by the author (the updated volume was released in 2007, so still wouldn't cover everything that has happened since.)

“Capital Ideas” The Improbable Origins of Modern Wall Street is considered a worldwide guide to modern investment theories and practices. Capital Ideas Evolving is a follow-up to this work & was published in May 2007. This is essential reading for those that want to understand modern investment theories.

I liked this book for the fact that it provided solid historical context for some of the work I do related to investments. It was written by the author of one of my favorite books, "Against the Gods". He does an excellent job of finding the middle ground between "ivory tower" academic theory and practical application.

In only giving 3 stars to Capital Ideas, I am in no way disparaging the work that Bernstein has done. In fact, the book is well-researched and well-written. No, rather I feel that in 2019, the book has not aged well - instead I would recommend those interested in finance and financial history to look elsewhere.

The main reason for this is the "market fundamentalism" (to borrow from Soros) that the book espouses. Having taken us through a sweeping overview of the development of modern financial theory, and despite a critical look at the short comings (particularly of portfolio insurance) in the crash if 1987, Bernstein ends the book almost apotheosising the founders of modern finance: "If we join the theorists in their fascination with free markets, we will find that they not only help us to appreciate what we have. They can also help us to make our system even better." (p306) Granted that Bernstein wrote this in 1992 (before Merton and Scholes' involvement in LCTM, before the financial innovation that led to 2008), but I can't help but feel even then a slight uncritical worship of modern financial theory. 1987 is brushed off as a mere"anomaly" (p304), but a true scientist would question the validity of a theory that would predict the occurrence of such moves as a less than one-in-a-lifetime.

So yes - the history of modern financial theory was an interesting read. But I would have preferred a more critical examination - maybe this requires a new edition, with a new last chapter in which Merton and Scholes are recast slightly, or an examination of some of the hazards modern financial theory has given us (indeed Bernstein hints at this in his examination of 1987, where he says portfolio insurance probably encouraged funds to hold larger equity positions than likely warranted).

I have read the book 5 months ago. So my review may seem a bit "shaky". However, I will do my best to give general idea without spoilers.

Capital Ideas is without doubt a must-read book for anyone who is interested in Finance as discipline and as part of Economics that is focused on the economics of markets in general. It is even a good book for those interested in Science.

The book explains the beginning of the financial markets more specifically the, as I call it, mother of markets which is the U.S market represented by Wall Street. Taking you through a historical journey into the minds and players who shaped Wall Street. Going into details about theories and tools most Finance professionals and Business Schools use Today!

As Finance student I learned a lot and I think it is an essential book to read. Its always better to know the roots of your major.

I borrowed this book from library because I was thrilled about reading another book written by the same author I after I read "Against the Gods: Remarkable Story of Risk", as I liked reading that book. The subject of this book was also interesting. It talked about the models used in financial market like CAPM, the evolution of portfolio theory, and conflict of ideas of rational vs behavioral economic study. It was all interesting. But subject is pretty heavy that I could not get a good momentum behind reading the book. I will surely get back to this book when my interest perks back to financial engineering and risk management.

A very readable account of how the key ideas of modern finance (modern portfolio theory, the efficient-market hypothesis, the capital assets pricing model, options pricing) were developed in a short period of 20+ years, and often by accident or from the fringes by people dabbling from other fields. Bernstein provides a great overview of the transformation of finance from a guessing game to a mathematical enterprise but perhaps expresses too much confidence that these new advances will overcome the vagaries of human behaviour.

I advise this book to anyone interested in finance & the financial tools & theories that shape the current financial world.

It is clear from reading this book that Peter L. Bernstien was a seasoned practitioner of finance & a seasoned writer of financial economics.
This book provides both a history & an introduction into important financial tools and theories, whilst staying grounded & on course with the subject matter.
Bernstien's delivery of emphasising the idea of known entities within an unknown domain & the ultimate limitations of doing so, I found to be a particular highlight.

Very well researched, but unfortunately a quite boring book to read. It started out on a very promising note - I read the first 100 pages literally before I went to bed and woke up the next morning with great enthusiasm to continue reading. Unfortunately, the book became a bit too technical for a book that I intended to read in my free time and thus progress was incredibly slow after the 200th page. It took me close to 3 weeks to finish a book that I intended to finish in 3 days tops

A little dated in the face of advances in behavioral economics, but a great comprehensive history of the development of the modern financial theories that influenced the way finance was taught to my generation of professionals.

Good for a financial layperson like myself. Interesting to know the academic history and personalities behind the prevailing theories of Wall Street. A lot of interesting information well packed into this book.

So that's where modern monetary theory came from!

A book that summarises the main financial ideas & innovations that academics have set forth up to the 1980s.

A superb chronology of finance theories and their applications in capital market.

Gostei mas acredito que poderia ter passado o mesmo conteúdo com metade do número de páginas.

The history of academic finance. Markets are efficient. Makes investing sound harder than diamonds.

Peter Bernstein outlines how a series of personalities (mostly from academia) mathematised financial sector theory over the 20th century. The researchers' early humility seemed an intuitive notion for those outside the jargon-laden wall street egos: security prices cannot be predicted with any degree of certainty. Despite this uncertainty and initial opposition to novel ideas, a number of theorists demonstrated that new concepts could be fruitfully applied to financial markets and instruments. Bernstein recounts this journey in 'Capital Ideas'.

Bernstein's first personality is Harry Markowitz, who revolutionised finance by introducing the concept of risk to portfolio allocation. Markowitz accordingly freed participants from Keynesian shackles proclaiming that holding diversified securities equated to an admission of ignorance by playing for averages.

There was a process to achieve Markowitz's optimal portfolio. An investor was to calculate the expected return on each security, identify covariances which existed between them, then rank each financial instrument according to their risk profile. The final step was to identify portfolios which have the highest return for each level of risk. This was how Markowitz established what he called the 'effective frontier'.

The method to achieve the effective frontier, however, required substantial computing power. Macroeconomist James Tobin assisted to simplify the process. He observed that market participants' asset preferences were not an either-or proposition between liquid or risky assets. Instead, investors should find an optimal mix of securities which do not vary with risk tolerance and combine this mix with risk-free assets like cash or bonds. Tobin's separation theorem created the diversified investor portfolio by injecting a more realistic depiction of investor psychology into financial theory.

Statistician Holbrook Working introduced the notion of security price's 'random walk' to finance. To demonstrate his research's validity, Working analysed wheat price movements over a one year period. These price changes were then plotted against a series of randomly generated numbers which fluctuated within the same band of commodity price movements. To give an indication of trader's market-beating claims, professional commodities traders were unable to pick which chart was real and which was the series of random numbers.

It took Paul Samuelson and Eugene Fama to relay accumulated academic findings at an institutional investor forum to gain professional traction. Fama and his graduate student's rigorous analysis concluded markets were very effective at pricing securities. Market participants' aggregate wisdom eventuated with the efficient markets hypothesis - that all available information is assimilated by the market, leading over time to accurate asset pricing.

The next intellectual theory in Bernstein's construction shifts from Fama's macro theories about market pricing efficiency to micro models seeking to understand the cost of capital in corporate structures. Franco Modigliani asserted that a financial officer's fundamental obligation was to optimise the company's debt-equity mix to maximise profit. Joint research with Merton Miller drew the conclusion that a company's market value is independent of its capital structure: borrowing and dividend distribution are inconsequential to share price. What matters instead is an enterprise's earning potential and risk.

Developed from William Sharpe and Jack Treynor's risk premium notion ('beta') in an investment portfolio, Capital Asset Pricing Model made a valuable contribution to the profession by combining a valuation of risky assets and expected returns on securities. Arbitrage Pricing Theory took the frictionless and transaction cost devoid CAPM one step further by incorporating fluctuations from other economic variables (interest rates, inflation, perceptions of risk etc) into its calculations. CAPM rounds out Bernstein's descriptions of various financial theory origins. He finishes off by examining options pricing, Ivy league academic theories' practical implementation (initially through Wells Fargo's banking trust business), index fund creation, tactical asset allocation, and portfolio insurance.

Overall, an accessible intellectual history of modern finance. Worth a read to discover the laborious processes involved translating theory into practice - especially to see steadfast resistance to unorthodox ideas which have subsequently become fundamental to the profession.

A walk through ideas in modern finance via biographical lens

While not what I would call exciting, this was interesting none the less.

"Capital Ideas" is a history of the people and papers which contributed to modern economic and financial theory. It's interesting to note that many things which everyone seems to accept as fact today with were unheard of 50 years ago. What will the next 50 years bring?

These few paragraphs summarize the tone and feel of the book nicely. While discussing the conflict which arose between the academics and the practitioners:

"Markowitz, for example, threatens the private preserve of portfolio managers by stressing the dominance of the portfolio over its individual components. That means that managers should not blithely stuff portfolios with their favorite picks, ignoring the overwhelming importance of diversification. In fact, the diversification Markowitz calls for often requires managers to hold stocks they do not like in order to balance out the ones the do like.

Tobin's Separation Theorem goes even further, by rejecting the conventional method of designing each portfolio specifically for each customer. Rather, Tobin prescribes identical equity portfolios for all accounts, regardless of objective or risk aversion. So who needs separate portfolio managers for each group of clients?

Security analysts are also vulnerable. Samuelson and Fama and their ilk argue that stock-picking is an activity doomed to fail and that technical analysis is a dangerous waste of time. If the stock market is efficient and stock prices are a random walk, who needs security analysts to make recommendations to portfolio managers?

The worst was yet to come. According to Sharpe, the market portfolio is the most efficient portfolio of all. If all you have to do is buy the market, or an index that replicates it, who needs anybody to cary on the traditional activities of a trust department?"

M. F. M. Osborne argues that, since stock transactions occur only when there is a difference in opinion on the value of the stock that, for the market as a whole, the expected price change is zero. Interesting way to look at things.

French mathematician Louis Bachelier proved decades ago that the vast majority of "investors" who trade actively do not beat market averages. The cornerstone concept has since become the foundation of many contemporary investment management concepts such as the Modern Portfolio Theory (MPT), the Modigliani-Miller theorem, and more relatively recent ideas such as "portfolio insurance" expounded by Leland and Rubinstein. Capital Ideas is a treatise on how these concepts were conceived and developed, and how these have shaped Wall Street as we know it today.

Good account of the origins of modern investment theory and analysis, as it came out of the Chicago School. I'd be mroe curious to hear Bernstein's reaction to the current economic crisis and whether the fundamental assumptions of the Efficient Market Hypothesis are inherently flawed. It's a shame we lost a great explainer earlier this year.

This was good. I think I would have enjoyed it more if I wasn't in the middle of law school. I had trouble devoting as much attention to it as I would have liked. Nevertheless, I felt that I learned a decent amount from it. I guess I was disappointed that the connections weren't made between the theories being explained and the effect on modern finance.